Euro-zone bank failures could cause U.S. credit squeeze - Kaufman

An illustration picture shows a one Euro coin being melted by a smith in Skopje, December 6, 2011.
REUTERS/Ognen Teofilovski

By Ellen Freilich

Euro-zone bank failures could lead to a credit squeeze in the United States, hurting an already subpar U.S. economic recovery, warned the well-known Wall Street economist Henry Kaufman.

A deterioration in the European financial system "could cause some of the American financial institutions to become more conservative and limit their own balance sheet expansion, a credit squeeze that would place a limit on the American economy," Kaufman said in an interview with Reuters.

"A failure in the euro-zone area, a malfunctioning of the euro, would have negative repercussions for the U.S. not just in terms of a slowdown in U.S. exports to Europe, but also because of linkage between American financial institutions and European institutions," said Kaufman, who is president of the economic and financial consulting firm bearing his name.

Kaufman earned the sobriquet Dr. Doom in the 1970s - long before Nouriel Roubini acquired the title in recent years. Like Roubini, Kaufman was prescient in his warnings about excessive debt in the financial system.

These days, with markets focused on Europe's excessive debt, he says severe spending cuts in southern Europe could send those countries into a downward spiral with no prospect of recovery.

"Debtor countries need to expand their economies and austerity measures diminish those countries' ability to grow and service their debt," Kaufman said.

Before establishing his eponymous firm in 1988, Kaufman spent 26 years at Salomon Brothers Inc. His prediction on August 17, 1982, that interest rates would fall sparked a stock market rally that helped kick off the 1980s bull market.

This year, the stock market has been held back by worries about Europe, where rising borrowing costs signify concerns that the debt contagion that has hit smaller nations will engulf large nations and large banks. The fear is exposure to European banks will hurt U.S. banks as well.

Big banks in Europe have sold large amounts of insurance in the form of financial instruments known as credit-default swaps to protect against the risk of countries defaulting on their sovereign debt, That has increased the number of parties that could incur losses if such defaults occur.

"We don't know the full depth of these links," Kaufman said in an interview with Reuters. That makes the European financial situation "hazardous" despite the ongoing effort by European policymakers to gain time, he said.

An expert on how credit flows through the economy, financial system and financial markets, Kaufman, who received the Foreign Policy Association's Statesman Award - presented by former Federal Reserve Chairman Paul Volcker earlier this month - said Europe will probably need "a major overhaul of its institutional arrangements" to escape its financial quagmire.

A combination of strategies will probably be needed to solve the euro-zone problem, he said. One would be to gain time for debtors to re-establish their economic capacity.

The head of Europe's bailout fund said on Friday around 600 billion euros were available to fight Europe's debt crisis, more than Italy's and Spain's combined funding needs for 2012.

Another strategy would be to reduce the debt of borrowers like Greece, Portugal or Italy, a reduction to which creditors would have to agree.

"That would require some private-sector institutions to take losses and/or that the debt of these marginal borrowers be transferred directly or indirectly to some official European institution such as the European Central Bank," he said.

Banks are resisting pressure to help indebted euro-zone countries by using cheap money lent by the European Central Bank to buy more sovereign bonds.

"Since none of these alternatives are easy, the conclusion must be that risks in Europe remain high," Kaufman said.

DEBT STANDS IN THE WAY OF RECOVERY

One huge obstacle in the path of more normal U.S. growth is the amount of non-financial debt relative to U.S. gross domestic product, Kaufman said.

On the eve of the 2008 financial crisis, non-financial debt exceeded U.S. gross domestic product by $19 trillion, while 20 years earlier, non-financial debt exceeded U.S. GDP by just $4 trillion, he observed.

"There are no easy ways to close that gap ... to return to a path of more sustainable U.S. economic growth," he said.

Households have been reducing their debt. Federal Reserve data showed household debt service levels fell in the third quarter, continuing a pullback from a peak reached in the third quarter of 2007.

Still, "total household indebtedness is still quite high by historical standards," Kaufman said.

Without the large borrowings of the U.S. government, the recession would have been deeper and the business recovery, subnormal as it is, would have been delayed, Kaufman said.

While the growth of U.S. government debt will have to slow in coming years, it is "quite unlikely" the U.S. government will adopt "appropriate fiscal policies" soon, he said.

"Near-term pressures are not strong enough to impose discipline, U.S. interest rates are historically low, and buyers of our debt are still easy to find," he said.

(Reporting By Ellen Freilich; Editing by David Gaffen and Jan Paschal)

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